PE investment in law firms: 6 considerations as MSO market enters next phase

Private equity’s (PE) expansion into professional services is reaching one of the few sectors that, historically, has remained largely outside the institutional investment model: law firms. This has quickly attracted the attention of lawmakers and regulators. While such attention does not spell the end of these types of investments, it signifies that things are already changing.

PE sponsors, law firms, and financing sources are increasingly evaluating management services organizations (MSOs) that allow outside capital to invest in firms’ business operations, enabling the MSO to support a law practice while preserving lawyer ownership and control of legal services and counsel. Early transactions in this space were concentrated primarily among personal injury firms. However, there has been an increasing number of MSO transactions in a wide variety of other types of law firms.

Legislators and regulators are taking note. Following related regulatory developments in Colorado and Illinois, California recently passed legislation addressing the potential influence of outside investors on litigation decisions. While the details of these initiatives vary by jurisdiction, the developing framework reflects several recurring principles: Investors should not control or influence lawyers’ professional judgment, lawyers must continue to protect confidential client information, and the economics between an MSO and a law firm must be structured to avoid impermissible fee sharing.

As transaction activity grows, the relevant questions for sponsors are shifting from whether an MSO can be created and toward the identification of structures that can withstand regulatory scrutiny, obtain financing, support growth, and ultimately deliver the economics contemplated at underwriting.

For sponsors evaluating the legal sector, consider these six issues from the outset.

Structural separation must be more than a diagram

The basic concept underlying a law firm MSO is relatively straightforward: A law firm performs two broad categories of functions, including the practice of law and the nonlegal business operations that support that practice. Under a typical MSO structure, the law firm continues to perform the legal functions while certain nonlegal functions, such as marketing, human resources, information technology, and other administrative services, are transferred to or performed by a separate MSO. Certain nonlegal assets, employees, and intellectual property (IP) also may reside at the MSO.

The two organizations are then connected contractually. The MSO generally provides services to the law firm pursuant to a management services agreement and may license IP to the firm under a separate licensing arrangement. Investors can acquire a minority or majority interest in the MSO while the law firm remains separately owned and controlled by lawyers.

The critical principle is that legal functions remain with the law firm. Lawyers must remain free to exercise independent professional judgment and represent their clients in accordance with applicable professional obligations.

This architecture will be familiar to healthcare investors. For decades, MSOs have been used to separate professional healthcare services from nonclinical business operations in jurisdictions restricting nonprofessional ownership of medical practices.

While this structural principle generally translates from healthcare delivery to legal practice, the regulatory framework does not. Legal MSOs must operate in compliance with professional-conduct rules specific to lawyers, and those rules must drive the structure of agreements from the outset, rather than being layered after the fact onto a pre-fab healthcare model. It is possible to separate professional services and judgment from nonprofessional operations, in large part because the architecture of such arrangements complies with the relevant regulatory regime. For sponsors of such transactions, the objective is to create an investable business services enterprise alongside a genuinely independent professional practice.

MSO economics are a central regulatory and underwriting issue

Given the requirements, the economic relationship between the law firm and the MSO is a key point of focus. In almost every state, professional-conduct rules restrict lawyers from sharing legal fees with nonlawyers. Because legal fees generally are the principal source of law firm revenue, the MSO will be paid from cash generated by the professional practice. The challenge is to design compensation for legitimate services and assets without creating an arrangement that could be characterized as impermissible fee sharing.

Depending on the applicable law and particular facts, potential approaches may include fixed fees, cost-plus arrangements, per-lawyer fees, consulting fees, and IP licensing fees supported by an appropriate valuation analysis. Earlier approaches that tied MSO compensation directly to a percentage of law firm revenue or profits present more significant concerns.

It is important to note that these analyses don’t end once the deal has closed. For example, a law firm that expands, post-transaction, through lateral hiring, geographic growth, or acquisitions may consume substantially more MSO resources and derive additional value from MSO-owned assets. The contractual framework therefore should be sufficiently flexible to enable the economics to evolve with the business. Potential mechanisms can include periodic fee reviews, updated IP valuations, and fee methodologies that scale with lawyer headcount or other measures of firm growth. Ultimately, the investment’s durability will significantly depend on the durability and defensibility of the financial relationship between the professional practice and the MSO.

Governance and lawyer retention require a different PE playbook

PE investors typically expect meaningful governance and contractual protections with respect to their investments. For law firm MSOs, such protections must be considered through a unique lens.

For example, in addition to the fundamental regulatory principle that an MSO investor cannot improperly control or influence the practice of law, lawyers also must preserve client confidentiality. As a result, governance rights that might be routine in another portfolio company typically require closer consideration in a law firm MSO. Investor protections should be designed to protect the MSO investment without migrating into decisions reserved for lawyers and the professional practice.

Lawyer retention creates another distinctive challenge. Traditional PE investments frequently rely on restrictive covenants to protect enterprise value. The professional rules applicable to lawyers significantly constrain that tool. The American Bar Association Model Rule 5.6, for example, generally restricts agreements that limit a lawyer’s right to practice, making conventional noncompetition protections particularly challenging in the law firm context. This rule increases the importance of economic alignment and thoughtful incentive design; depending on the structure and applicable requirements, potential mechanisms to address these industry-standard restrictions may include MSO equity vesting or forfeiture, deferred consideration, and clawback arrangements.

From an underwriting perspective, law firms also can have substantial key-person and concentration risk. When underwriting law firm MSOs, financing sources should be prepared to examine lawyer retention, partner economic incentives, and revenue concentration by partner, among other factors. Sponsors also should consider, early in the investment process, how the structure will keep key lawyers aligned with the platform when conventional restrictive covenants may not provide the protections available in other industries.

Financing is developing into its own law firm MSO workstream

The emergence of a more sophisticated financing market may be one of the strongest indications that law firm MSOs are beginning to mature as an investment category. Historically, law firm lending was concentrated among a relatively small group of sector specialists. More recently, a developing cohort of direct lenders has emerged that can underwrite law firm MSO transactions at pricing in line with, or at a modest premium to, other sectors.

That said, financing a law firm MSO involves much more than applying conventional leveraged buyout financing to a new industry. Lenders must take into account a recurring set of sector-specific issues, including lawyer retention and key-person exposure; case generation and barriers to entry; contingency versus hourly revenue and revenue visibility; collections and receivables; regulatory put mechanics; the durability of the MSO structure; transaction ethics; and concentrations by partner, case, referral source, geography, and practice area.

Law firm MSO transaction documentation can also involve concepts unfamiliar to lenders entering the sector for the first time. An effective financing structure will address the issues noted above, as well as business services agreements, nonlegal asset transfer agreements, licensing arrangements, continuity agreements, and indemnification arrangements.

Ultimately, financing considerations should inform transaction architecture from the beginning rather than being addressed after the MSO structure is complete. A transaction that satisfies the sponsor and law firm but cannot support the contemplated financing may fail to deliver the capital structure assumed in the investment thesis.

The structure should be designed for the second transaction, not just the first

The initial transaction is only one stage in the life cycle of a PE investment. As noted above, a sponsor may expect to expand the platform through lateral hiring, additional offices, new partnerships, or acquisitions. Other strategies include investing in technology and marketing; increasing MSO earnings before interest, taxes, depreciation, and amortization; refinancing the business; and, ultimately, pursuing an exit option that may involve selling its investment. Each of these initiatives can place additional pressure on the original structure.

Further, multistate expansion requires analysis of jurisdiction-specific professional rules. Growth may require adjustments to management fees and licensing arrangements. Add-on transactions can introduce new-partner economics and governance considerations. Financing sources may require additional structural protections. And a successful exit typically requires creating an MSO structure that remains workable under new ownership.

Despite some fundamental differences, the healthcare MSO market provides useful lessons with respect to such life cycle issues. While law firm MSOs involve a different regulatory framework, many of the transaction pressure points are recognizable: Management fee mechanics, governance alignment, multistate expansion, and exit risk need to be considered when the platform is formed and through add-ons, financing, and an eventual exit. A structure designed only to complete the initial transaction is likely to be substantially less valuable than one designed to support the sponsor’s full investment thesis.

Regulation may be defining the market, but it is not closing it

California is just the latest example of how increased transaction activity in the legal sector has brought increased legislative and regulatory attention. There, the state legislature recently passed legislation aimed at preventing outside investors from controlling or improperly influencing litigation decisions, including decisions regarding client selection, representation terms, settlement, and legal strategy. The legislation follows developments in Colorado and Illinois also addressing PE investment and law firm MSOs.

These developments should be taken seriously. They are likely to affect transaction structures, economic arrangements, and documentation and compliance obligations. Sponsors pursuing multistate strategies will need to account for differences among jurisdictions. However, these developments also point toward a maturing market.

The recurring regulatory themes (professional independence, client confidentiality, and separation between investor economics and legal fees) are largely focused on the boundary between legitimate investment in the business infrastructure surrounding a law firm and impermissible investor participation in the practice of law. This is a natural evolution: As investment grows, scrutiny will grow with it. The structures most likely to endure will be those designed from inception around genuine professional independence, defensible economics, and meaningful separation between the investor-owned MSO and lawyer-controlled practice.

PE sponsors are evaluating opportunities. Law firms beyond the first wave of personal injury practices are considering the model. Financing sources are developing sector-specific underwriting frameworks. And legislators and regulators are beginning to establish more explicit boundaries around outside investment.

All of this has led to increased scrutiny. Investors and law firms must now make decisions and build structures designed for that scrutiny. Within these structures, professional independence should be genuine; economics should be defensible; key lawyers should remain aligned; financing considerations must be addressed from the outset, and transaction architecture should be prepared to accommodate growth, multistate expansion, and an eventual exit.

While other sectors provide a useful precedent and law firm MSOs involve a different rule set, the larger lessons carry over: The most durable structures are not those designed to get around professional regulation. They are those designed to work within it.

McDermott was an early leader in developing the MSO structure. Contact the authors or your McDermott lawyer to learn more about how we can draw on our experience with law firm MSOs and healthcare private equity to help drive your success.